Canadian stock market since COVID‑19: Why a V-shaped price recovery?

The stock market fell ill in early 2020

The value of Canadian firms trading on the Toronto Stock Exchange fell in February and March 2020. The S&P/TSX Composite index dropped by 37 percent between February 19 and March 23, 2020—the date the index hit its lowest point during the COVID-19 crisis. This is a drop of around $1 trillion in the value of those firms, and it corresponds to about half of the annual Canadian domestic output the previous year. The reason for this decline is that forecasts for these firms’ future earnings plummeted as the pandemic evolved. Like most stock markets around the world, the TSX index had fallen ill, and its health deteriorated rapidly, adding to the stress of unprecedented uncertainty.

Surprisingly, global stock markets, including the TSX, have recovered most of their losses (Chart 1). By the end of August 2020, the TSX index showed a decline of around less than 10 percent since February. The V-shaped recovery pattern—resulting from the plunge followed quickly by the rally—is puzzling. Estimates from Statistics Canada show that the Canadian workforce shrank by around 3 million jobs between February and May 2020. Given the abrupt economic slowdown and the uncertainty around the future recovery, it is easy to wonder if the stock market rally is disconnected from the real economy. The signal sent by the stock market is also puzzling because the V‑shaped pattern varies across industries and even across companies.

Chart 1: The TSX 300 recovered most of its losses

Source: Bloomberg Last observation: September 10, 2020

To examine this puzzle, we look at prices of individual stocks on the TSX index throughout the V-shaped episode. We then break the change of individual stock prices into two parts:

• change due to increases in the rates at which investors discount future earnings back to the present
• change due to lower forecasts for future earnings

First and unsurprisingly, we find that the plunge in firms’ stock prices in February and March can be attributed to a rise in the rate at which investors discount future earnings. This discount rate increased from 10 to 15 percent on average across stocks. However, the discount rate returned close to its early-February level by August.

Second, we find that the 8 percent decline in the TSX index between February 19 and early August 2020 aligns well with declines in firms’ earnings that stock market analysts forecasted. While the future may prove the analysts wrong, the current equity price and earnings forecasts appear in line with each other. This suggests that the stock market is not disconnected from the economic conditions that analysts anticipate. We reach the same conclusion whether we use the average or the most pessimistic forecasts. We also ask whether the Shopify stock is driving the TSX index recovery because it experienced large gains during this period. However, excluding Shopify from the analysis also does not change our conclusion.

Discount rates drove the stock markets plunges

We estimate the discount rate for future earnings using:

• the price of a stock
• the forecasts by analysts for firms’ annual earnings for three years into the future
• an estimate of a firm’s long-term growth

The discount rate we estimate is a measure of the compensation that investors in the stock market earn for bearing risk. We follow the calculations and analysis Landier and Thesmar (2020) use for the United States. The average discount rate we extract across stocks in the TSX index increased from 10 percent to close to 15 percent when the index plunged (February 19 to March 23). Chart 2 shows that the discount rate has since returned to the level it was at before the COVID‑19 shock. This tells us that the discount rates drove the market plunge, and revisions to earning forecasts seemed to play essentially no role in the early stage of the crisis.

Chart 2: The discount rate has returned to level it was before COVID‑19

Sources: Bloomberg, Refinitiv and Bank of Canada calculations Last observation: September 10, 2020

Indeed, the wide swing in the discount rates is consistent with information about tail risks revealed from the prices of options on the TSX index during this period. Chart 3 shows that the probability of a large drop in the value of the TSX index spiked early in March 2020 but has been slowly recovering since.

Chart 3: Tail risk probabilities from TSX options mirrored the discount rate swing in March

Sources: Bloomberg and Bank of Canada calculations Last observation: September 10, 2020

2020 earnings forecasts were severely downgraded

Publicly traded firms report their profits in terms of earnings per share (EPS). Analysts closely follow firms’ EPS—commonly called the “bottom line”—when firms announce their earnings results. Most analysts forecast firms’ annual EPS for several years into the future. They publish and regularly update these forecasts, which are collected by Refinitiv and disseminated in the Institutional Brokers’ Estimate System (IBES) database.

Chart 4 shows that EPS forecasts for 2020 fell by 52 percent on average across the TSX index, starting in the second half of March 2020 (blue line). The decline is less pronounced for earnings forecasts for 2021 and 2022, which were revised down by 18 and 13 percent, respectively.

Looking back to history, we find that the reduction in earnings that analysts expected for 2020 is much larger than the earnings’ reduction they expected early in 2009, during the global financial crisis (Chart 5). However, the revisions in EPS forecasts for 2021 and 2022 are similar to the revisions for 2010 and 2011. This suggests that stock market analysts are projecting a lingering recovery for firms’ EPS, as they had in 2009.

Sources: Bloomberg, Refinitiv and Bank of Canada calculationsLast observation: September 10, 2020

Revised earnings forecasts explain lower value

The decline in earnings forecasts largely explains the decline in the value of the TSX index we observe at the end of August 2020. Chart 6 compares average stock returns and revisions in EPS forecasts for different industries. Industries whose stock values plunged deeper were also those with the steepest revisions to EPS forecasts, on average. This gives us confidence that changes in earnings forecasts play an important role in the change to the stock market value between February and August 2020.

The energy sector stands out: 2021 earnings forecasts were revised down by close to 83 percent, and stock values fell by roughly 43 percent on average between February 19 and September 10, 2020. Even if the energy firms are excluded, the positive relationship between stock prices and revisions to forecast earnings is pervasive across other sectors.

Chart 6: Earnings forecasts guide stock valuations across sectors

Sources: Bloomberg and Bank of Canada calculations Last observation: September 10, 2020

Lower interest rates largely offset the higher risk premium

Chart 7 breaks down the changes in the discount rate since the beginning of 2020 between compensation for risks—the risk premium—and the decline in long-term interest rates. The risk premium in August 2020 is around 1.1 percent higher than the level it was before the COVID‑19 crisis. This increase is, however, largely offset by lower interest rates, which are partly due to the responses of the Bank of Canada since the start of the crisis.

Chart 7: The decline of interest rates helped offset the rise in risk premium

Sources: Bloomberg, Refinitiv and Bank of Canada calculations Last observation: September 10, 2020

Discussion

Our results are consistent with Kyeong’s (2020) observation that the value of firms that are more sensitive to economic slowdown appear to predict a slow and shallow economic recovery, which contrast with the signal we get from the value of firms that are less sensitive. Indeed, in unreported results, we find that firms that are more sensitive to economic slowdown suffered the largest decline in earnings forecasts so far. Broadly speaking, there is a divergence after the COVID‑19 crisis between:

• firms in the energy, financial, and real estate sectors, whose prospects severely deteriorated; and
• firms in the materials and technology sectors, whose prospects might have improved.

Our conclusion is also robust. We repeat our calculations using the most pessimistic earnings forecasts for each firm at each point in time. On average, the discount rates that we obtain in this way are lower. For instance, the peak is 13 percent in March 2020, about 2 percentage points lower than the estimate based on average forecasts. However, the market-wide discount rate at the end of our sample is still very close to the level prevailing at the beginning of the year. This result implies that the market valuation in September is aligned with the average decline in earnings forecasts across firms.

Finally, our results rely on estimates of each firm’s long-term growth beyond 2022, which we match to the observed growth in sectoral sales over the previous business cycle. These growth rates have a mean of about 3.9 percent and a range between 2.8 and 4.9 percent. However, we confirm that our conclusions remain unchanged if we estimate this rate of growth using different approaches (e.g., analysts’ estimates of long-term growth).

Looking forward

The apparent disconnect between the economic outlook and high stock prices raises questions. But we find that the decline in the value of the TSX index between February and August 2020 aligns well with earnings forecasts by stock market analysts. This does not mean that that the analysts’ lower forecasts and the current market value are the best predictions of what is to come. Even more, it does not mean these forecasts will be right. In June, the International Monetary Fund said that the gross domestic product for advanced economies will be lower at the end of 2022 than it was at the start of 2020. The Bank of Canada painted a similar picture for Canada in July (Bank of Canada 2020). More research is needed to determine how closely analysts’ forecasts of firms’ earnings relate to projections for the Canadian economy.

References

1. Bank of Canada. 2020. Monetary Policy Report (July).
2. Kyeong, J. 2020. “Is the stock market pricing in a V-shaped recovery?” Bank of Canada Staff Analytical Note No. 2020-17.
3. Landier, A. and D. Thesmar. 2020. “Earnings Expectations in the COVID Crisis.” HEC Paris Research Paper No. FIN-2020-1377.

Acknowledgements

We thank Guillaume Bédard-Pagé, Hayden Ford, Tamara Gomes, Maxwell Knifton and James Kyeong for helpful comments and suggestions. Finally, we are grateful to Nicole van de Wolfshaar and Colette Stoeber for editorial assistance.